1. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 1 Legal Liability Chapter 5

2. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 2 Learning Objective 1 Understand the litigious environment in which CPAs practice.

3. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 3 Changed Legal Environment Audit professionals have a responsibility under common law to fulfill implied or expressed contracts with clients. They are liable to their clients for negligence and/or breach of contract should they fail to provide the services or not exercise due care in their performance. Despite efforts by the profession to address the legal liability of CPAs, both the number of lawsuits and sizes of awards to plaintiffs remain high.

4. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 4 Changed Legal Environment o Growing awareness of responsibilities of public accountants by users of financial statements o Increased consciousness of the Securities and Exchange Commission (SEC) for its responsibility for protecting investors’ interests o Complexity of auditing and accounting functions caused by increasing size of businesses, globalization of business, and complexities of business operations oTendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of fault (“deep-pocket” concept of liability) o Large civil court judgments against CPA firms awarded in a few cases encourage attorneys to provide legal services on a contingent-fee basis – offers the injured party a potential gain when the suit is successful, but minimal losses when it is not o Willingness of many CPA firms to settle legal problems out of court in an attempt to avoid costly legal fees and adverse publicity, rather than resolution through judicial process o Judges’ and jurors’ difficulty in understanding and interpreting technical accounting and auditing matters Major contributors:

5. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 5 Learning Objective 2 Explain why the failure of financial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits.

6. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 6 Business Failure, Audit Failure, and Audit Risk  Business failure It occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions.

7. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 7 Business Failure, Audit Failure, and Audit Risk  Audit failure It occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards.

8. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 8 Business Failure, Audit Failure, and Audit Risk  Audit risk It represents the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can be issued when, in fact, they are materially misstated.

9. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 9 Learning Objective 3 Use the primary legal concepts and terms concerning accountants’ liability as a basis for studying legal liability of auditors.

10. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 10  Lack of privileged communication  Liability for the acts of others  Prudent person concept Legal Concepts Affecting Liability

11. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 11 Legal Terms Affecting CPAs’ Liability Terms related to negligence and fraud:  Ordinary negligence  Constructive fraud  Gross negligence  Fraud

12. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 12 Legal Terms Affecting CPAs’ Liability Terms related to contract law:  Breach of contract  Third-party beneficiary

13. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 13 Legal Terms Affecting CPAs’ Liability Other terms:  Common law  Joint and several liability  Statutory law  Separate and proportionate liability

14. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 14 Four Major Sources of Auditors’ Legal Liability  Liability to third parties  Federal securities laws  Liability to clients  Criminal liability

15. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 15 Learning Objective 4 Describe accountants’ liability to clients and related defenses.

16. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 16 Liability to Clients The most common source of lawsuits against CPAs is from clients.

17. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 17 Auditor’s Defenses Against Client Suits  Lack of duty to perform  Nonnegligent performance  Contributory negligence  Absence of causal connection

18. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 18 Learning Objective 5 Describe accountants’ liability to third parties under common law and related defenses.

19. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 19 Liability to Third Parties Under Common Law  Ultramares doctrine  Foreseen users

20. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 20 Foreseen Users  Credit alliance  Restatement of torts  Foreseeable user

21. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 21 Auditor Defenses Against Third-Party Suits The preferred defense is nonnegligent performance.

22. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 22 Learning Objective 6 Describe accountants’ civil liability under the federal securities laws and related defenses.

23. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 23 Securities Act of 1933 The Securities Act imposes an unusual burden on the auditor. Section 11 of the 1933 act defines the rights of third parties and auditors.

24. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 24 Securities Exchange Act of 1934 The liability of auditors under this act often centers on the audited financial statements issued to the public in annual reports or submitted to the SEC as a part of annual Form 10-K reports.

25. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 25 Rule 10b-5 of the Securities Exchange Act of 1934 Section 10 and rule 10b-5 are often called the antifraud provisions of the 1934 act.

26. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 26 Auditor Defenses – 1934 Act  Nonnegligent performance  Lack of duty  Absence of causal connection

27. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 27 SEC Sanctions The SEC has the power in certain circumstances to sanction or suspend practitioners from doing audits for SEC companies. In recent years, the SEC has temporarily suspended a number of individual CPAs from doing any audits on SEC clients.

28. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 28 Foreign Corrupt Practices Act of 1977 This act makes it illegal to offer a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business.

29. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 29 Sarbanes-Oxley Act of 2002 This act requires the CEO and CFO to certify the annual and quarterly financial statements filed with the SEC. Management must report its assessment of the effectiveness of internal control over financial reporting. The auditor must issue an opinion on the effectiveness of internal control over financial reporting.

30. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 30 Learning Objective 7 Specify what constitutes criminal liability for accountants.

31. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 31 Criminal Liability CPAs can be held liable under criminal liability for accountants. CPAs can be found guilty for criminal action under both federal and state laws.

32. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 32 Sarbanes-Oxley Act This act makes it a felony to destroy or create documents to impede or obstruct a federal investigation.

33. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 33 Learning Objective 8 Describe what the profession and the individual CPA can do and what is being done to reduce the threat of litigation.

34. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 34 The Profession’s Response to Legal Liability  Research in auditing  Standard and rule setting  Set requirements to protect auditors  Establish peer review requirements

35. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 35 The Profession’s Response to Legal Liability  Oppose lawsuits  Education of users  Sanction members for improper conduct and performance  Lobby for changes in laws

36. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 36 Protecting Individual CPAs from Legal Liability  Deal only with clients possessing integrity  Hire qualified personnel  Follow the standards of the profession  Maintain independence

37. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 37 Protecting Individual CPAs from Legal Liability  Understand the client’s business  Perform quality audits  Document the work properly  Obtain an engagement and a representation letter  Maintain confidential relations

38. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 38 Protecting Individual CPAs from Legal Liability  Carry adequate insurance  Seek legal counsel  Choose a form of organization with limited liability  Exercise professional skepticism

39. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 5 - 39 End of Chapter 5